Investors get constructive on home-builder shares

Earnings season will be critical test after housing stocks rally

By

JohnSpence

BOSTON (MarketWatch) -- Home-builder stocks have been at the forefront of the market's recent charge on hopes the economy and housing markets are stabilizing, but the rally could be short-lived if second-quarter earnings reports disappoint.

The SPDR S&P Homebuilders ETF
XHB, -0.39%
jumped 14% last week and has gained even more ground since then in volatile trading.

Indeed, housing-related stocks have been among the market's top performers since the March 9 market low. On that day, the home-builder ETF touched an intraday low of $8 a share. The sector fund closed July 20 at $12.77 a share, a rise of about 60%.

Markets were cheered by a Commerce Department report last week that housing starts rose to a seven-month high in June. See previous coverage.

"June housing starts gave further evidence that single-family housing production may have bottomed in January," said Morningstar home-builder analyst Eric Landry. "Whether this bottom is temporary or enduring is difficult to discern, but the current trend in single-family production is now pretty clearly up."

The report was another tepid signal that the housing market may be bottoming out. Also last week, the National Association of Home Builders said its sentiment index rose more than economists had expected. Read more.

Yet there are concerns the shares are getting ahead of themselves as investors brace for quarterly losses from residential builders, coupled with data that could show continued sales and price deterioration in the U.S. residential market.

Bears say mounting job losses and a dearth of credit will result in further pain. Housing prices peaked in 2006.

"Most importantly, housing data are still reflecting the effects of massive government housing stimulus, which is wearing out," said Nishu Sood, an analyst at Deutsch Bank. "While it is possible that earlier stimulus may have kick-started the housing market, we doubt it because homebuyers' economic headwinds are still strong."

"Prices are down by 32%, and we expect that the overhang of vacant housing and distressed sales will push pricing down a further 12% or more," says Merrill Ross at BGB Securities.

Other challenges include a rising tide of foreclosures that is adding to the supply glut of unsold homes, and declining homeownership rates and consumer confidence. The Federal Reserve has been trying to hold rates down by buying Treasurys and other securities, but a rise in mortgage rates could temper any recovery.

'Unprecedented slowdown'

Some analysts say home-builder stocks aren't out of the woods yet despite the recent bump higher.

"Overall, we continue to believe inventory will remain elevated and demand suppressed well into 2009 due to a high level of foreclosures, the expiration of federal and California tax credits, rising unemployment, weak consumer confidence, and still-tight credit conditions, which should continue to pressure the stocks," said J.P. Morgan's Michael Rehaut.

The $8,000 credit for first-time homebuyers is set to expire on Dec. 1. Investors will be looking for any color from builders on whether the deadline is fueling buyer urgency.

Big home builders set to report quarterly financial results this week and next include NVR Inc.
NVR, -0.29%
Standard Pacific Corp.
SPF, +10.53%
Ryland Group Inc.
RYL
and MDC Holdings Inc.
MDC, -1.52%
On Thursday, markets will digest a report on June existing home sales, followed by new-home sales next week.

"New-home sales are the cleanest indicator of housing demand, so if gains in new home sales match those in starts, that would be evidence that there has been a genuine rebound in housing demand; however, we don't expect that to be the case," Deutsche Bank warned.

"An unprecedented slowdown in the U.S. housing sector may be nearing the end, but public builders will need to keep costs and expenses in check through next year," added Fitch Ratings.

"There are more positive signals and developments for housing and related industries now than at any time previously in the downturn," Fitch said. "Of course, challenges remain or are on the horizon, which may not prevent a near-term bottom, but are likely to meaningfully moderate the early stages of a recovery."

Even though there could be more upside in housing-related stocks, Ed Yardeni, founder of Yardeni Research, forecast they will underperform the S&P 500 Index
SPX, +0.59%
during the second half of the year and in 2010.

One wild card is whether the government can take steps to ease foreclosures.

"The outlook for these stocks isn't as grim as was widely feared late last year, but it certainly isn't great given the overhang of unsold new and existing homes, which may take longer than usual to work down during the coming recovery," Yardeni said.

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